Inflation lecture 3


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Inflation Lecture 3

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Inflation lecture 3

  1. 1. Lecture 3:<br />Measuring Inflation <br />and <br />Deflation<br />
  2. 2. Recap<br />Inflation has internal and external impact on the economy.<br />Internal : <br />Redistribution of income:<br /> i) Fixed vs Variable income earners<br /> ii) Creditors vs Debtors<br /> iii) Government vs Taxpayers<br /> iv) Firms vs Consumers<br />
  3. 3. Recap<br />Internal:<br />Consumption & Savings<br />Investment & Production<br />Economic Growth & Unemployment<br />E) Menu and Shoe-Leather Costs<br />F) Distortion of Price Mechanism<br />External :<br />Imports & Exports<br />Growth & BOP<br />
  4. 4. Measurement of Inflation<br />In Micro, we look at price of individual <br />markets, e.g. F1 tickets, rice, cigarettes.<br />In Macro, we look at GENERAL PRICE LEVELS: Average prices of G&S in economy.<br />Misconception: “Aiyoh, the chicken rice price got more expensive by 50¢ to $3, but how come the Straits Times say inflation is only 5% wor!”<br />Inflation is measured by CPI.<br />
  5. 5. Consumer Price Index [CPI]<br />Measures the price changes of a fixed <br />basket of G&S bought by the average <br />household in a specified time period.<br />Fixed basket: With the quality and quantity of goods held constant, changes in CPI only reflect changes in prices. <br />Fixed basket: composition is representative of expenditure patterns of typical household. <br />E.g. Food, Health, Transport,<br />Housing, Recreation, etc. <br />
  6. 6. Consumer Price Index [CPI]<br />Measures the price changes of a fixed <br />basket of G&S bought by the average <br />household in a specified time period.<br />Specified time period: A base year is chosen and the CPI of basket of that year is 100<br />120<br />20%<br />-33%<br />80<br />
  7. 7. V Look at the data…<br />Pg 16<br />121-106 X 100%<br /> 106 <br /> = 14%<br /> 6<br />In 2007, prices grew by____%. <br />In 2008, prices grew by _____%. <br />Overall, between 2006-2008, prices are __________________________.<br /> 14<br />increasing at an increasing rate <br />Can you visualize the <br />price-time graph?<br />
  8. 8. Consumer Price Index [CPI]<br />Measures the price changes of a fixed basket of G&S bought by the average household in a specified time period.<br />Weights are assigned to reflect the relative importance of each item in the basket. The larger the expenditure, the larger the weight <br />CPI = <br />[Weight x Price Index] of every item<br /> Total Number of Weights<br />Pg 16<br />CPI= [5x110+3x120+2x130]/10<br /> = 117<br />
  9. 9. Singapore’s Weighting<br />How would<br />the average<br />household be <br />affected by<br />droughts in<br />Australia and<br />China, and <br />high oil prices?<br />
  10. 10. Limitations of CPI<br />Different income groups have different<br />consumption patterns: difficult to find <br />“average” household<br />Expenditure patterns change with changes in taste and preferences and emergence of new products. Ipods in 1998?<br />Weights have to be updated. For example, with income rising, people spend less on essential goods, such as food, and more on luxury goods<br />Changes in quality are not reflected in CPI. <br />E.g. LCD TV<br />
  11. 11. CPI and GDP Deflator<br />Recall: GDP Deflator = Nominal GDP x 100=<br /> Real GDP<br />GDP Deflator= an index of the average prices of all components of GDP or domestically produced G&S, while<br />CPI= an index of prices of basket of specific items consumed by average household.<br />GDP Deflator compares the prices of currently produced G&S to the prices of the same G&S in the base year, while<br />CPI compares prices of fixed basket of G&S<br />
  12. 12. CPI and GDP Deflator<br />How would CPI and GDP Deflator <br />register the following differently:<br /><ul><li> A significant cut in prices of Toyota </li></ul> cars given the recent safety scandal<br /><ul><li> Soaring rice prices due to natural disasters in Thailand and Cambodia
  13. 13. A surge in the price of armoured vehicles produced by Singapore Technologies
  14. 14. Skyrocketing oil prices as political tension in Middle East worsens</li></li></ul><li>Deflation<br />Definition: Sustained fall in General Price Levels.<br />V What are the effects of Deflation?<br />Pg 20<br /><br />
  15. 15. Effects of Deflation<br />Consumers<br />Deflation increases the value of money, increasing the purchasing power of consumers<br />Falling prices of assets means the wealth of consumers is reduced.<br />Recall: Real i/r = Nominal i/r - inflation<br />If inflation is now negative, Real i/r> Nominal i/r!!<br />This means that cost of borrowing <br />While the increase in value of money strengthens purchasing power, it also means that real value of debt <br />What about consumer sentiments?<br />
  16. 16. Effects of Deflation<br />Producers<br />With lower consumption levels,<br />profit margins of firms will <br />Poor business outlook would also mean<br />that firms would have no incentive<br />to invest to boost productive capacity.<br />Investment <br />To increase profits, firms cut costs by laying off workers.<br />Retrenchment lowers income levels and worsens consumer sentiments.<br />Falling I and C exerts downward pressure on prices.<br />With prices falling, consumers and firms withhold <br />expenditure. Prices fall further…..<br /> DEFLATIONARY SPIRAL sets in<br />
  17. 17. Effects of Deflation<br />With falling<br />C and I, AD falls, lowering prices further.<br />Consumers and <br />producers will <br />further withhold<br />C & I<br />Output and GPL  <br />It is very difficult for the economy to get out of deflationary spiral if<br />consumer and investor sentiments worsen.<br />GPL<br />AS<br />AD1<br />AD2<br />AD3<br />AD4<br />P1<br />P2<br />P3<br />P4<br />Y3<br />Y4<br />Y2<br />Y1<br />Real GDP<br />
  18. 18. Recap<br />Inflation measures the changes in General Price Levels<br />Measured by Consumer Price Index [CPI]<br />Items in the CPI basket are fixed and are representative of consumption patterns of average households<br />
  19. 19. Recap<br />Weights are assigned to items to represent their relative importance<br />Main expenditure in Spore includes food, transport and housing.<br />While both GDP Deflator and CPI measure inflation, their composition is different.<br />
  20. 20. Recap<br />Deflation= sustained fall in GPL<br />Falling prices will:<br /><ul><li>Decrease wealth
  21. 21. Increase real value of debt
  22. 22. Increase real cost of borrowing
  23. 23. Lower profits for firms
  24. 24. Lead to retrenchment as firms cut costs
  25. 25. Lead to fall in C & I, and further fall in prices
  26. 26. Worsen consumer and investor sentiments
  27. 27. Result in deflationary spiral</li></li></ul><li>Cost-push inflation<br />Definition: Increase in GPL due to increase in cost of production not brought about by excess demand.<br />Cost-push inflation<br />GPL<br />A<br />Faced with higher costs of production, firms will i) cut back on production [AS shifts left]<br />ii) pass the costs to consumers [AS shifts upwards]<br />AD<br />AS3<br />AS2<br />Prices rises while real output falls.<br />AS1<br />During the Oil Shocks in 1970s, GPL soared. AS shifted upwards, leading to low growth and higher inflation, i.e. STAGFLATION<br />Yf<br />Y3<br />Y1<br />Y2<br />Real Output<br />
  28. 28. “The pursuit of growth always leads to higher inflation.” Discuss.<br />What kind of growth?<br />Real/Short-term Growth?<br />Potential/Long-term Growth?<br />Real Growth= AD shifting outwards<br />Whether real growth will lead to significant <br />inflation depends on state of economy/<br />amount of spare capacity.<br />Boom? Recession?<br />
  29. 29. “The pursuit of growth always leads to higher inflation.” Discuss.<br />What kind of growth?<br />Real/Short-term Growth?<br />Potential/Long-term Growth?<br />Potential Growth= PPC/AS shifting outwards<br />Increase in productive capacity will help<br />improve structural bottlenecks.<br />Higher productivity also means unit cost is lower.<br />Hence potential growth alleviates inflationary pressure.<br />
  30. 30. “The pursuit of growth always leads to higher inflation.” Discuss.<br />It is the<br />pursuit of BOTH<br />real and<br />potential growth<br />that allowed <br />Singapore to <br />enjoy robust <br />economic growth<br />while keeping<br />Inflation in check.<br />GPL<br />AS1<br />AS2<br />AS3<br />AD3<br />AD1<br />AD2<br />P3<br />P2<br />P1<br />Y1<br />Y2<br />Y3<br />Real GDP<br />
  31. 31. Based on what you know about the Singapore Economy, <br />a) what would be the major sources of inflation for us?<br />b) what should we do about it?<br />c) why are we so concerned about inflation?<br />
  32. 32. Lecture 3:<br />Measuring Inflation <br />and <br />Deflation<br />